Blog outlining massive fraud in the Australian listed investment company (LIC) and broader financial sector

Thursday, 27 February 2014

The game theory of oligopoly pricing

Every single spruiker of the sharemarket explicitly or implicitly assumes a high degree of market efficiency. Absent market efficiency, there would be no benefit to making even the "right" investment, as you could not expect price rises to follow improved fundamentals, and investing would make no sense. Efficiency is what separates a "market" from a "scam". In the absence of market efficiency, there is no possible justification for allocating a single cent of pension money to the sharemarket. Market efficiency is assumed when using market prices as the best available estimate of value. In fact, it does not even make sense to talk about "market prices" without assuming a high degree of market efficiency. The market tautologically is efficient.

There are a number of necessary conditions for an efficient market, some of which are esoteric (homoscedasticity) and most of which are patently untrue (rationality of expectations). The most basic yet often overlooked assumption is that of many buyers and sellers, none of which individually can move prices. If a market has but a few participants, that individually affect prices, market efficiency can not be assumed.

A large and growing number of shares in the Australian market now have such concentrated ownership they can not be regarded as trading at a "market" price. Major fund managers often dominate the share registers and without any question individually affect prices. The efficient market framework is not helpful for such an oligopoly of market-moving players. The reason for this is that in an oligopoly, player actions affect prices as well as the decisions of other players. Analysis of oligopolies thus necessitates game theory. In an efficient market there is no such need, as individual buyers or sellers have no impact on price, and thus no impact on each other. The game theory of oligopoly markets has both competitive and cooperative aspects. Repeated interactions among the oligopoly players increase the likelihood of successful cartel cooperation.

Such mechanics will be most obvious in the case of an illiquid share held by a small handful of players, with a current "market" price far above any reasonable fair value. Assuming an efficient market, each player would have an incentive to sell relentlessly. In an oligopoly framework, each player would realize such a decision's effect on price and on other players, and have an incentive to not collapse the book value of their holding.

The rise of investing intermediaries such as fund managers (as opposed to direct personal ownership) has separated ownership and control, and introduced a separate set of incentives that ultimately distorts prices. Since financial intermediaries derive cash fees from unrealized profits, there will be a systematic bias toward ramped prices unsupported by fundamentals. A market dominated by a few major financial intermediaries will thus be much more predisposed to boom-and-busts, as opposed to a market with highly distributed direct ownership. Boom-and-bust is embedded in the very fabric of the current market structure. Laws that by design funnel pension money to financial intermediaries exacerbate the problem.